Standards of Greatness

Standards of Greatness

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hat does it take to be a really great actively managed equity fund? By what margin must one beat the competition? Or is simply beating this-or-that benchmark index sufficient to claim superiority?

Pragmatically, performance superiority is both a relative standard and an absolute standard. Greatness is relative in the sense that an actively managed fund must beat its peers (a group of relatively similar actively managed funds) to have a legitimate claim to greatness. Greatness is absolute in the sense that benchmark indexes have essentially been canonized and thus represent an absolute standard against which all other funds are measured.

This article provides some "parameters" for carrying out such relative and absolute comparisons among actively managed U.S. equity mutual funds over the five year period from 1999-2003. The data for this study were gleaned from Morningstar Principia. Index funds were excluded as were redundant portfolios. Thus, the funds being analyzed were distinct (i.e. only one share class included from multiple share class funds) U.S. equity funds which had at least 12 months of performance at the end of each of the five years being analyzed.

Survivor bias and style drift from year to year were eliminated from this data set. This was accomplished by extracting the needed data from each year-end version of Principia for the five year period being studied rather than extracting 5 years worth of data from the 12/31/2003 release of Principia. Five providers of U.S. equity indexes were utilized in this study, namely Barra, Dow Jones, Morningstar, Russell, and Wilshire.

This study utilized two research methodologies worth briefly noting. First, benchmark index returns (used in absolute comparisons) were presented as an average of five indexes, rather than using the return of just one index. There is too much variance among U.S. equity indexes to rely upon one index as being representative of any particular market cap and style sector. It is my opinion that the industry would be well served by averaging the performance of several indexes for purposes of benchmarking, rather than relying upon the performance of a single index.

Secondly, the 75th percentile five year annualized return (as will be seen in Figures 1 and 2) that was calculated from each year's 75th percentile annual return is a novel approach. This five year annualized return (used in relative comparisons) is "theoretical" in the sense that it was not achieved by one fund in particular, but rather is representative of the best results (top quartile) from each year's cap/style-specific funds (regardless of whether or each year's best funds survived the entire five year period). This technique establishes a level of performance that creates a very demanding "relative comparison" standard.

Let's start first with U.S. equity value funds in Figure 1. The performance parameters for a relative comparison are highlighted in blue and include average return in each of the five years, the annual 50th percentile return (or median return), and the annual 75th percentile return. Averaged index returns represent the parameters for an absolute performance comparison and are highlighted in purple.

For example, the 50th percentile return (i.e. median return) in 1999 for large cap value (LV) funds was 6.1%. The median return indicates that half of the 230 funds had a return equal to or higher than 6.1% and half of the funds had a one year return lower than 6.1%. Finally, 25% of the LV funds (or the 75th percentile) had a return equal to or higher than 12.2% during 1999. The same information is provided for midcap value funds and small cap value funds. Figure 2 includes comparable data for growth funds.

The last column in Figures 1 and 2 is the five year annualized return for each array of annual returns and represents a compact comparison figure when conducting relative comparisons among actively managed funds. The choice of which figure to use (average return, median return, or 75th percentile return) is a function of how stringent you want the comparison to be. Generally speaking, average return and median return are fairly similar (with the possible exception of small cap funds). Using the five year annualized 75th percentile return creates a very demanding relative comparison standard. For example, only 18 LV funds had a return in excess of the 5 year annualized 75th percentile return of 6.7%, whereas 118 funds exceeded the raw average return of 2.7%.

In each of the five years, the 75th percentile return for LV funds was higher than the average return of the five indexes. Simply put, using the 75th percentile return as the comparison figure provided a more demanding test than using the average return of the five indexes. In fact, even using the median return for LV funds (2.6%) was more stringent than the five LV index five year average return of 2.2%. Over this particular five year period, relative performance was a stricter judge of greatness among LV funds than was an absolute comparison against the average return of LV indexes.

In the midcap value category, the average return of the five indexes exceeded the 75th percentile return in two years (2000 and 2003) suggesting that absolute comparisons of actively managed MV funds against MV indexes is a reasonable measure of greatness. However, as the five year 75th percentile return of 15.2% exceeded the five year average index return of 10.2% it is clear that a relative comparison using the top quartile of funds is an even stricter standard.

Among small cap value funds, the most demanding comparison is a relative one utilizing the five year 75th percentile return. An absolute comparison against the average return of the five indexes (12.3%) was comparable to a relative comparison using the median (or 50th percentile) five year return of 12.1%.

Among growth funds (large, mid, and small) the most demanding comparison to reveal great funds was, by far, a relative one in which the 75th percentile return was utilized. In fact, a relative comparison using the 50th percentile return was even more stringent than an absolute comparison against the indexes among large cap and small cap growth funds.

This analysis suggests that relative comparisons among actively managed equity funds may be more effective in identifying great funds than absolute comparisons against index benchmarks.

Figure 1. Value Funds

Figure 2. Growth Funds